Like it or not, recessions and economic contraction are a part of the market cycle and such environments can also create some of the best opportunities for early-stage companies to thrive.

A lot of VCs (including myself) have been giving similar advice to founders on how to navigate difficult environments: “you need to cut the operating expenses and reduce your burn rate, you need to postpone your fundraising plan and extend your runaway to at least 18–24 months”.

It all makes sense — but in reality, it is a bit harder than that if you are an early-stage founder and you have never experienced something similar before.

In this post we want to outline the “most important metrics” VCs use to assess and screen investment opportunities during a recession, according to the experiences of a selection of early-stage investors (thanks Susie, James and Olly) across different stages and industry verticals.

However, as Howard Mark writes, there exists no single formula, algorithm, nor playbook that unlocks a universally accepted approach to assessing early-stage investments.

In order to master startup metrics, the first step is specifying exactly what “the most important” metrics are for a specific company. We recommend founders to select one or two key performance metrics (KPI) relevant to the problem they are trying to solve and that captures the needs of their clients.

Particularly during a booming market, there is a prioritization of taking market share, and therefore investors mostly focus on revenue and growth evaluating early-stage investments. But during a recession, the music typically changes, and investors tend to scrutinise items such as profitability, retention rate by cohort and runaway.

Clearly, different metrics serve different purposes, and the topics touched on in this post are extremely simplified. Valuation and investing are more of an art than a science and in order to draw a big picture, we are conscious we must sacrifice some details. Comparing companies between different industries and different business cycles is challenging, but we wanted to provide some guidelines nevertheless, based on our personal experiences as investors, and show how our focus on evaluating investments has shifted in the current environment.

1. Burn rate (and Runaway) 💸

Burn rate is the pace at which cash is decreasing. Especially in a recession, it’s important to know and monitor burn rate as companies fail when they are running out of cash and don’t have enough time left to raise funds or reduce expenses, particularly if the environment is not favourable.

The average burn rate is simply given by the cash balance at the beginning of the year minus cash balance at the end of the year divided by twelve. But It is important to distinguish net burn vs. gross burn:

Gross burn rate corresponds solely to the amount of cash that you spent in a single month (cash outflows). Net burn rate subtracts the total revenue from the total amount of money spent month-over-month. So net burn rate is your actual cash lost in a single month.

Similarly, to calculate the runway, take the amount of available capital and divide by the net burn burn rate to get the number of months until your start-up runs out of cash. These numbers show the efficiency of a business, the timeline for fundraising, and the need for capital.

While startups are often run quite cheaply until their first external fundraise, VCs will want to understand how you will sustainably increase your expenses to grow the business more quickly following new capital injections. As mentioned before, during a recession VC will often ask you to control operating expenses and extend the runaway to face the unknown (like in the matrix below).

Source: Sequoia

However, despite the current environment, most early stage investors still expect their entire investment to be spent within 18–24 months (green quadrants of the table) to fuel growth. So if you’re raising $5 million, but your monthly net burn rate is “only” $100k (50 months runaway), you may want to develop a clear plan on how the burn rate is going to accelerate, and how that will propel the growth of the business.

2) The Rule of 40 with Susie Meier, Notion Capital ⚖

The “Rule of 40” is a crucial metric for SaaS businesses, in particular during times of recession. Why? Because it analyses the company’s health, by looking at the two most important parameters: its growth rate and its profit margin.

First of all, it is essential to understand that the Rule of 40 applies exclusively to SaaS companies vs. other non-software subscription businesses.

Think about the dichotomy of the margin levels: on one hand, non-software subscription companies typically have much lower margins, as their Cost of Goods Sold include buying the physical underlying asset/raw materials.

On the other hand, SaaS companies usually have high margins (80–95%) as the costs to serve a new customer with the existing software product are generally negligible, apart from minor costs (i.e. hosting).

Secondly, the Rule of 40 also becomes more relevant for Series A companies and onwards. For very early-stage/seed companies with 1–2 big customer wins per year, the metric simply does not provide the most valuable insights.

Instead, very early-stage SaaS companies should rather focus diligently on unit economics first (i.e. ARPA, CAC, LTV, Churn etc.).

The Rule of 40 is really just a rule of thumb, following a simple calculation adding up the company’s growth rate and its profit margin, i.e. Magic Number = Growth rate + Profit margin. The sum of which should be adding up to at least 40%, hence the “Rule of 40”.

So in practice, if you are growing at 100% year-on-year, a negative profit margin of up to -60% could still be considered acceptable. However, if you are growing at only 10% year-on-year, you should be generating a profit margin of at least 30%. Anything above 40% is generally seen as healthy.

Let’s dive into the 2 key components here in more detail. For the growth rate, you can obviously measure it in a bunch of different ways, but the most widely accepted way is to look at year-on-year MRR growth. As for the profit margin, you can equally measure it in numerous different ways, but the most common approach is to simply use EBITDA, rather than any GAAP accounting lines such as Net income, Free Cash Flow etc.

It is undoubtedly key to understand your company’s health, and especially in a recession, you really need a strong grip on your metrics that display a potential mismatch between growth and profitability.

While the benchmark will always be 40% regardless of economic circumstances, there is a trade-off in place between the two elements, and one might seem more feasible or desirable than the other in a recession. So, in general, you can afford to lose money as long as you’re growing fast enough, which is why VCs usually inject equity in your company.

And as you’re probably focusing on achieving monopoly in certain geographies or verticals to become the winner that takes it all, you might accept to sacrifice profit for growth.

In a recession, however, fundraising is notoriously more difficult and the key is to extend your runway — which in turn means that you might want to shift your focus to profitability over growth.

Summing up, the rule of 40 is absolutely fundamental to late-stage SaaS businesses, but in particular during recessions as it demonstrates the trade-offs you should weigh against each other: profit or growth.

3) Profit margins with James Baker, Amadeus Capital🧾

If the Rule of 40 is a SaaS company’s health check-up, then profit margins are the detailed diagnostics on the profit side of the Rule of 40 equation. In recessionary times when a startup sees their sales growth dropping, it is imperative for companies to understand their margin structures and where they have the leverage to course-correct, reduce burn rate, and improve their fundamentals.

There are two main margin-levels to consider in this respect:

• Gross margin
• EBITDA margin

Gross Margin:

The core of any business, and its ability to be successful over time, will depend almost entirely on its ability to generate and expand gross margins. The core tenant here is that every business, whether SaaS or non-SaaS, tech or non-tech, needs to be able to sell goods for less than it costs to make and provide those goods to the customer.

As Susie pointed out, historically SaaS companies have been so enticing to investors because they have almost perfect gross margins, largely thanks to the internet and cloud-based deployment, making the cost of supply almost zero.

Selling software this way and scaling it globally has made some of the most valuable companies in the world such as Salesforce, DataDog, and Slack. The value of such high gross margins is that it provides a significant amount of cash to flow into operating expenses, including those costs that can help fuel rapid growth such as marketing and sales.

Recently however as tech companies have moved from the cloud to “real life”, we have seen the rise of hybrid-tech and deep tech companies.

These businesses by nature have higher COGS due to the need for hardware, leases, or human capital — resulting in lower gross margins (c. 50–60%). The largest issues for these companies is that gross margins often expand with scale, however inversely they contract or remain stagnant with low or no growth.

Gross profit, therefore, provides a quick measure to assess the business model. What is included in gross profit may vary by company, but in general all costs associated with the manufacturing, delivery, and support of a product/service should be included. So be prepared to break down what is included in — and excluded — from that gross profit figure.

Early-stage companies often don’t have a lot of leverage in their gross margins, meaning it’s very difficult to actively manage and move gross margin quickly in times of crisis. Nevertheless, for the bold and innovative there are opportunities to reassess your business model and pricing structure — both of which could help improve your gross margins.

EBITDA margin:

For investors and companies alike, EBITDA margin is just as important as gross margin — especially in times of crisis. EBITDA is a proxy for operating cash flow and so provides a snapshot of how much money an early-stage business is burning, allowing a rough-and-ready understanding of how long a business can survive for.

The difference between gross margin and EBITDA margin is the inclusion of operating expenses (like advertising, rent, salaries, fixed costs, etc.).

While gross margins for tech companies are usually positive and large, EBITDA margins are often significantly negative. This is because in recent times investors were focusing on companies winning sizable market share and then figuring out the rest — meaning huge cash spending on sales, marketing, and growth.

But recently, we have seen some hyper-growth punished by the public market for having poor EBITDA margins (e.g. Uber, Lyft, Farfetch, Eventbrite etc.) with ramifications on the early-stage market.

When financial uncertainty prevails, it’s suddenly no longer a “smart play” to bet on a startup that will lose millions, before turning cash-flow positive. Instead, companies managing costs more tightly and with the ability to conserve losses at the expense of explosive growth, while preserving revenue, will be more appealing in economic downturns (so-called “camels”).

As a result, we are now experiencing that many early-stage investors are trying to work alongside startups to fix unit economics (CAC, LTV, Churn, etc.) and reduce operating expenses to maximize runway.

Valuations are also significantly revised (WeWork valuation dropped from $47B to $2.9B in one year) as investors see through top-line bookings growth for early-stage businesses but want to understand if it was achieved at the expense of profitability.

What is now expected is “managed losses”, which provide the most efficient path for growth with the ability to flip to profitability when necessary. In tough economic times, it is all about agility and reacting quickly to market conditions to ensure company survival.

Focusing on your EBITDA margin is really about focusing on the leverage you can gain in your operating costs — which means being as efficient as possible with your allocation of capital — especially when it comes to growth, marketing, and fixed costs. This focus on efficiency may force early-stage companies to make significant opex cuts if their revenue is impacted by the current economic climate.

In summary, investors increasingly want start-ups to have more robust unit economics, and prove how they can improve contribution over time through operational efficiency.

There is no one-size-fits-all approach, but understanding your business model, being lean and agile, and setting your business up to come out of this ready to accelerate growth, is a must in a recession. Focusing on the two main financial margins will help early-stage companies in this fight.

4) LTV (Lifetime Value):CAC (Customer Acquisition Cost) ➗

When you’re considering the direction your company is taking, the ratio Lifetime Value (LTV) / Customer Acquisition Cost (CAC) is one of the most important metrics to understand. But let’s first break down the two components.

Lifetime value (LTV):

It can be defined as the present value of the future gross margin from the customer over the duration of the relationship. A common mistake is to estimate the LTV as a present value of revenue generated from the customer, instead of calculating it as gross margin of the customer (or sometimes gross profit) over the life of the relationship.

Let’s say that on average you retain a customer for 5 years, and the customer spends 100$ per year. At an average gross margin of 50% this means that your LTV is $250 ($100 x 50% x 5 years).

LTV is important because it suggests the upper limit on what you can spend on customer acquisition. Particularly during a recession, you may want to go back to the basics, focusing more on increasing the ARPC (Average Revenue Per Customer) rather than expanding a loss-making user base.

Customer acquisition cost (CAC):

CAC is the full cost of acquiring users, stated on a per-user basis (Marketing expenses + Sales Expenses/New Customers). Simplified numerical example in the Google Sheet below:

Source: Andrewchen.co

To adapt this spreadsheet for your own calculations, click here, then go to File > Make a copy to create your own version.

Unfortunately, CAC metrics come in all shapes and sizes. A common problem is that founders calculate CAC as a “blended” cost (including organic and paid new users). While the fully blended number is interesting, it does not give an investor a lot of information about the single channels of acquisition.

Therefore, investors often split this into paid and free channels CAC. Free acquisition is a new client starting using a product without seeing an advertisement, perhaps through word of mouth.

Paid CAC is generally synonymous of marketing and it tends to be more important than blended CAC for investors, as it informs whether a company can scale up its user acquisition budget profitably.

CAC usually increases gradually as you try and reach a larger audience. So, it might cost you $50 to acquire your first 100 users, $100 to acquire your next 1,000, and $500 to $1,000 to acquire your next 10,000. That is why you simply can’t afford to ignore the metrics about volume of users acquired via each channel.

In the long term, LTV must exceed CAC to create a viable business. Otherwise, the company will never be able to internally finance product development, general and administrative overhead, or new marketing campaigns, and it will never create profits for owners.

Generally speaking, a ratio greater than 3:1 is considered “satisfactory” but that’s not necessarily the case. Often, the math comparing CAC and LTV is imperfect as there are additional costs to retaining customers, which product and marketing teams rarely take into consideration. That’s why, in normal circumstances, we tend to prefer a ratio closer to 4:1.

However, LTV:CAC ratio calculated from company data only becomes relevant when the growth process becomes both repeatable and scalable, therefore we acknowledge that during a recession this ratio can temporarily get lower and still be acceptable (ideally we would still want to see something > 2:1) if the company provides a clear strategy on how gradually increase the ratio overtime (example below).

Source: Pretiosum Ventures data

X. “When Monetization is not a thing” with Oliver Kicks, RLC Ventures🆓

For revenue-generating businesses, measuring what matters is crucial. But for companies that are pre-revenue and pre-monetisation, there are other aspects of your business to focus on.

Companies such as Facebook, Google, and YouTube began life with user acquisition and engagement as the priority, and had they gone to market with a paid product, they would most likely not be the companies that they are today.

Especially in the seed and early stages, focusing on revenue and commercialisation may shift founder focus away from arguably the most important metric or measurement — product-market fit.

Companies who go to market too early, without a product or service that the end-user loves, will ultimately struggle to sell their product and see sustainable long-term growth.

Often VCs will say “we need to see some traction or early revenue before investing”, and often this will put pressure on the founding team to ship a premature product. When it comes to the Enterprise Software and B2B/SaaS landscape, demonstrating that someone will pay for a functional MVP is a good indicator of the value of the product to the end customer.

It is important to strike a balance between proving value through early customers and shipping a product that is valuable enough at the right time.

When it comes to Product-Market Fit (PMF), Rahul Vohra from Superhuman describes most ways of assessing or measuring PMF as ‘lagging’. If you want to really understand whether or not you have it, you need to ask your customers “how would you feel if you could no longer use the product?” and measure the percentage who answer “very disappointed.” If under 40% answer along the lines of very disappointed, then the company most likely hasn’t achieved PMF.

If your company is badly impacted by Covid, and your sales process as you know it is deeply disrupted, it could be worthwhile spending some time on:

• Product
• User Segmentation
• Sales Strategy

Product:

As churn creeps up across many reporting dashboards across the world, fighting fires on the sales front may be futile for the time being. Ultimately, unless you are a core piece of software that companies cannot operate without right now (e.g. Zoom, Dropbox, Microsoft Office) then you can probably expect to see some churn.

Instead of chasing down new leads and opportunities, the slowdown in sales activity presents a great opportunity to focus on product and features. Even companies that have raised multiple rounds of funding and are seeing millions in annual revenue have probably created a somewhat bloated product, with some redundant or unnecessary features. You can take this time to trim-back the offering, and think about which features are painkillers (needed) vs. supplemental vitamins (nice to have)?

User Segmentation:

Similarly to reassessing the product, taking some time to step away from the sales process and to re-map your users and customers can be an extremely valuable process, and help influencing how you prioritise roadmap features and future sales endeavours. What percentage of your customers are Enterprise customers? How many are SMEs? Scale-ups? Individual freelancers? Agencies?

For each of these groups, messaging and marketing materials can be redrawn and re-assessed to match the newly streamlined product, and highlight the end value your product or service is providing to the customer.

This process will also give you some key insights into your sales pipeline and can be matched alongside the Churn data you might have collected recently. Where does the most churn lie? Who is least likely to stop paying for my service? Below a typical example of a “cigarette analysis” outlining the breakdown of the monthly recurring revenue at risk.

Source: ‘Predictive Churn Indicator’, by Augustin Sayer

The data gathered from times of economic turmoil could be useful for times of growth, as you look to understand who you could best upsell and extract more value from.

Sales Strategy:

If the last two processes were undertaken thoroughly, some interesting insights will most likely have emerged. Using these insights to better prepare and inform future strategy will be an invaluable process, and will help to really drive growth when typical sales processes can resume.

Few companies, however, are not waiting for the market to come back, and they are using the widespread changes to acquire new users. Peloton has really understood this opportunity, and through extending its free trial from 30 days to 90, “bumped its digital subscriber numbers from 100,00 to 1.2 million.”

Any short or near term opportunities should be pursued, but not at the cost of long term focus for the company.

The impact of Coronavirus will most likely be reduced from here on out, and reshaping your whole product will not necessarily benefit your business long-term.

Conclusions

When initially evaluating businesses, investors often look at the top-line (GMV, revenue and bookings) because they are the best indicators of the size of the business. But then, they will want to understand the growth to see how well the company is performing.

During a recession, the focus should not just be on gross growth month-to-month but also on efficient and sustainable growth (like seen above).

Extensive user base and manageable burn rate (and runaway) for Fintech companies, a robust “rule of 40” for SaaS, sustainable and growing gross margins for marketplaces, solid retention rate for games and personal apps and a LTV:CAC ratio around 4x for productivity tools, are some great examples of how a single metric can be the defined as the most important for your company.

But every investor has their own approach, and every startup is unique, as such, the “most important metric” does not exist.

These metrics are just a start. If you can get the data, It makes sense to compare yourself to companies operating in the same industry and of similar size and stage of development.

But to really be valuable and help you achieve your milestones; you also need to come up with measures that are specific to your business only.

Most importantly, quantitative metrics are informative about various dimensions of a startup’s performance, but they are not always conclusive proof of the value of a startup.

Robust products with great design, rockstar team with previous exits, knowing your clients’ needs better than anyone else, unique go-to market strategy, and other areas are just as vital to the success of a business. Outstanding metrics are probably necessary to successfully fundraise (particularly in this environment), but they are not usually sufficient to guarantee a successful long-term outcome.

Great companies are built from greatness, both quantitative and qualitative and there is not such a thing as “the most important metric”.

This article was originally published by Luca cartechini on medium.